Krugman Still Wrong on Federal Spending and the Economy

A not-so-small cottage industry has grown up refuting liberal economist Paul Krugman’s public pronouncements. It’s not a hard industry to join, and there’s plenty of work, but it can be repetitive. Even so, Krugman’s recent writings opposing federal spending cuts for the sake of the economy are sufficiently troubling to warrant yet another go.

Krugman’s misguided conclusion is simple enough: Increasing budget deficits by increasing spending helps a weak economy, while cutting spending and budget deficits hurts the economy. The key to deriving this conclusion is what Krugman refers to as “excess saving.” Specifically, total demand in the economy is too low because individuals and businesses are saving too much. Government deficits can soak up this excess saving and turn it into demand, thus moving the economy back toward full employment.

Would that it were so, but it’s not. If excess saving existed, and if that saving were in a form government borrowing could tap, then the theory would have merit. But as explained elsewhere in more detail, there is no excess saving in the sense Krugman means.

Krugman’s theory breaks down because it ignores another little industry known as financial markets. Financial markets are vastly complicated and wonderfully efficient most of the time. They evaluate asset prices, assess risk, and sometimes overpay executives. But above all, the central role of financial markets is fairly simple. It’s called “intermediation.”

As the term suggests, intermediation involves acting to intermediate between two other parties. It means facilitating some manner of economic arrangement. And what is that economic arrangement precisely? It is putting those with excess saving today in contact with those who need capital today. Financial markets connect savers to borrowers, turning excess saving into demand-boosting purchases—all miraculously without the hand of government lifting a finger.

Financial markets provide loans and equity to those who want to borrow to buy a car or a home, to businesses that want to expand or upgrade their facilities, and so forth. Where does that money come from? Former savings become current investments.

The upshot of this discussion is that steady, sustained reductions in federal spending are not a threat to the recovery, though they are essential to economic growth in the years ahead.

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JD Foster is the Norman B. Ture Senior Fellow in the Economics of Fiscal Policy at The Heritage Foundation. His primary focus is studying long-term changes in tax policy to ensure a strong economy. He also examines changes in Medicare, Medicaid and Social Security so they are both affordable and more effective.

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